JP Morgan ESG EMD indices – our initial thoughts

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JP Morgan recently unveiled their suite of ESG EMD indices – with ESG versions of the GBI-EM (local EMD), EMBI Global Diversified (hard currency sovereign) and CEMBI Broad Diversified (hard currency corporate). As proponents of ESG integration in emerging market debt space, we welcome this move as an important step forward in providing investors with a benchmark for ESG integration. Below we briefly outline the construction of these indices and our thoughts on what this means for investors.

A brief summary of JP Morgan’s approach

The starting point for index construction are the traditional indices.

JP Morgan then adjust the weights based on a composite ESG score of each issuer.

This ESG score is derived from credible third party sources: Sustainalytics, RepRisk and the Climate Bond Initiative with monthly updates based on (albeit limited) real time data.

ESG scores are converted into five ESG bands which serve as a multiplier to the original index weight.

This leads to a set of indices that (relative to traditional JP EMD indices) overweight green bonds, up-weight or down-weight issuers based on ESG scores, and exclude certain issuers based on threshold scores and an ethical screen based on certain indicators.

Historically, these indices have provided comparable returns to their non-ESG counterparts, while displaying better credit quality and resilience during down-markets.

We view this as an important step forward

The ESG indices fill an important gap in the market and provide asset owners with a dedicated ESG benchmark to measure portfolio performance against.

Importantly, by using their flagship indices as a starting point, the indices do not sacrifice diversification, liquidity, yield, etc and have a similar historic performance signature.

The customisability of the indices is also welcome: sector exclusions can be reduced or expanded, the green bond overweight can be switched off, to meet client-specific requirements.

We thus think the indices are an important step forward for asset owners wanting to more explicitly incorporate ESG in their EMD portfolios.

Just one part of an array of approaches to ESG

However, the development should not be viewed as a panacea. For instance, the methodology focuses purely on the ‘level’ of ESG and doesn’t adjust for economic development. Hence Turkey’s weight in the EMBI is upgraded in the ESG version, while African countries are generally downweighted. This in theory will lead to a smaller allocation of capital to the poorest emerging/frontier markets and lowers their capacity to transition or deal with ESG shortcomings. Thus for some investors, a different approach may be required. Indeed the new JP Morgan Indices should be seen as just one of an array of approaches to sustainable investing. The Global Sustainable Investment Alliance (GSIA) outline seven categories of sustainable investment:

Exclusionary Screening

Positive Screening

Norms-based screening

ESG integration

Sustainability themed investing

Impact investing

Engagement

The JP Morgan ESG indices include a combination of ESG integration with exclusionary screening for the worst offenders.

For those asset owners with long-term, socially responsible investing goals, a more comprehensive solution may be preferred. Such a solution may combine a number of the GSIA’s categories, such as sustainability themed investing, engagement and screening.

Importantly such an approach would have a dual mandate; not just an investment objective but an explicit (and measurable) ESG objective. It would focus a lot more on future trends in ESG metrics across issuers (rather than backward looking data used to determine the index weights). Clearly it should also include engaging with the issuers to impact such trends positively.

Our comprehensive sovereign and corporate ESG scorecards provide an effective and flexible framework for a more active ESG approach. It helps inform our ESG scores in our standard investment process, but also provides a framework for a tailored solution for clients wishing to meet specific ESG goals, from a broad list of objectives (supporting the sustainable development goals) to thematic (action against climate change).

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